The debt trap and how to avoid it

When you finance your company with debt, in the form of convertible or regular loans, there is a risk that you will fall into what is called the “debt trap”: you run out of equity (“aktiekapital”) before you run out of money. It is not be confused with the situation where your debt burden simply becomes too great to pay off. It is also closely related to the problems you run into with a traditional convertible loan, which gives the holder the right, but not the obligation to convert the loan into shares when the loan matures. To illustrate, let us take a simplified example :

An example

Your company is a regular Swedish joint stock company (“aktiebolag”) with a minimum share capital of 25 000 kr. You have a plan to develop a software product in one year which will cost 2 million kr, after which you will start getting revenue from product sales. So you plan to finance this with a convertible loan of 3 million kr as well as a shareholders contribution from the founders of 400,000 kr, in order to have some safety margins. When the product is launched you will still have 1.4 million kr in cash, which you hope will be enough reach profitability, or at least give you time to raise money in a proper share issue, at which time the plan is to convert the convertible loan into shares. As an incentive, you promise the holders of the convertible a discount on the share issue of 20%. So if you raise money at 10 kr per share, the convertible holders are entitled to convert their loan at 8 kr per share. If there is no share issue when the convertible loan matures, the holder of the convertible loan has the option of either converting the loan at a fairly low valuation (say 4 kr per share) or be paid back.

It may now look like the company is well financed. However, if you are not careful, you may run into multiple problems here. The first is your equity. If you follow your plan and book your development costs as regular costs, your (simplified) balance sheet will look like this after year one:

The problem now is that despite the fact that the company has well over a million kr in the bank, and is following its plan, it is technically insolvent, since the convertible loan is treated as a debt that needs to be repaid. Even before you reach this point, when half of the share capital has been used up, the board is obliged to create a balance sheet for liquidation purposes – “kontrollbalansräkning” in Swedish – and must then restore the share capital within 8 months, or liquidate the company. If the share capital is not restored, then the board of the company assumes personal liability for all costs incurred after that point, which obviously is very dangerous and should be avoided.

Capitalizing development costs

A short term solution to the above problem is to capitalize the development costs (“aktivera utvecklingskostnaderna” in Swedish). This means that whatever is developed, the software in this case, is treated like an asset which is written off over five years. The cost of development is 2 million kr, and the first 20% is immediately written off, so in our example, by the end of the year, the software represents a value of 1,6 million kr and our simplified balance sheet would look like this:

However, this only buys the company a little time. If the company loses more than 12 500 kr one month, then it is again technically insolvent, since half of the share capital will then be gone.

Even assuming that things go according to plan, there is a built in problem in this financing solution. Let us assume that after this point the company starts selling its product and breaks even, for example by the founders taking very low or no salaries. We are then at a point where the company is doing OK from a bookkeeping perspective, but it has not yet achieved a sustainable level of revenue. Let us also assume that the company is not successful in raising money through a share issue. What happens then when the convertible loan matures?

Since the company is not doing so great, the convertible loan holder may not be so keen on converting the loan into shares. After all – that won’t bring any new money into the company; it would only relieve the company of the obligation to pay back the convertible loan. The convertible loan holder would then have an incentive to demand a payback.

Risk of fire sale

This puts the company in an really bad situation. There is not enough money to pay back the convertible, and the only way to get any money quickly may be to do a fire sale of the assets, that is the software that has been developed. Assuming that it is possible get 80% of the development costs when selling the software in this way, that is to get 1,6 million kr. Then the company would have just enough money to repay the convertible (the 1,6 million in the sale plus the 1,425 million it has in cash). So now the company is back at the beginning with no product (since it has been sold) and the founder’s shareholders contribution has been lost.

And this is actually a positive scenario. Selling a software project before it has become a mature money spinner is usually not easy, and a much more likely scenario would be a bankruptcy where everyone loses whatever they contributed.

But what if the company is doing really well? Let’s assume that the software flies off the shelf, and when it is time to pay back the convertible loan, the company has 4 million kr in the bank, and will be able both to pay back the convertible loan and to continue its operation and generating even more profit. In this situation, the incentive for the founders of the company is to pay back the convertible, which they no longer need, while the convertible holder has the exact opposite incentive; since the company is doing so well, converting is a no-brainer.

Summary

So to sum up: if you finance the development with a convertible loan that can be paid back, the incentives for the holder of the convertible and the founders will be perfectly misaligned: when the company needs the money, the convertible holder will want their money back, and when the company does not want conversion, the convertible holder will insist on it. And even if you agree on conversion, you still have the problem with the risk of running out of equity before you run out of cash. In our example above, this was avoided by having the founders making a shareholders contribution.

The solution to the above requires two steps:

1. The convertible loan must be equity capital, not treated as a loan
2. Conversion must be mandatory. If both the company and the holder of the convertible knows before hand that conversion will happen, then both can plan accordingly, and you avoid the misaligned incentives.

This happens to be precisely what our product WISE does. Want to know more? Book a demo and we will show you how to easily set it up yourself.